How to Win in the Secondaries Market

A conversation about competition, leverage, and relationship dynamics in the secondaries market.

A robust private equity secondaries market is a sure sign of a maturing private equity market. Across the globe, the secondaries investment business itself has become fiercely competitive, with billions of dollars in dry powder chasing increasingly sophisticated sellers. In this Privcap conversation, experts from Pantheon and Abbott Capital discuss the latest trends in secondaries, what effect leverage is having on deals, and how buyers are seeking to stand out in a crowded market.

Privcap: What kind of a year was 2015 for secondaries investors?

Martha Cassidy, Abbott Capital: 2015 was characterized by the absence of an expected volume of regulatory divestitures. And while there were some, there were not a lot. The year also saw the emergence of restructurings as a meaningful user of secondary capital, in which existing private equity firms, with their general partner management groups, undertook some form of resetting of the economics.

Rudy Scarpa, Pantheon:  2015 also saw an increase in the amount of mature funds being sold in the secondary market.  For example, pre-global financial crisis funds made up a large portion of the secondary transaction volume. That shouldn’t be a big surprise, given the large amount of capital raised by private equity funds in 2006, 2007  and 2008.

From a buyer’s perspective, however, the challenge with acquiring some of these older funds is pricing, particularly as an increasing amount of NAV is dominated by public positions.  As a result, a discount to NAV is required for a secondary buyer to generate a reasonable return.

Privcap: When buying into a mature fund, are you removing much of the uncertainty around what the GP will do with dry powder?

Scarpa: There’s certainly less blind pool risk. But a key factor in all these deals is the quality of the general partner.  So, even in the more mature funds where you may find a lot of public positions, you want to be invested with the higher quality managers because they are better at optimizing the value of their portfolios, regardless of market conditions.

Cassidy: That’s worth amplifying. The benefit of a quality manager can’t be underestimated, which is why the economic incentives and alignment need to be as strong as possible.

Privcap: Talk about the growing trend for secondaries buyers to use leverage with the hope of boosting returns.

Cassidy: The significant emergence of the use of leverage probably started in 2014 within the universe of both large and small funds. This can take the form of a working capital line, if you will, attached to a secondary fund. It can also take the form of a third-party loan, often provided to a pool of larger assets.

That’s had the effect of enhancing returns and allowing prices to go even higher. A related effect is that it displaces dry powder, which otherwise would have been called to fund these transactions. So that’s just changed the landscape.

There are an awful lot of people who seem to be lending money. At our size, being a smaller fund, we wouldn’t typically be using leverage. It would be cost prohibitive. But if we were spinning a $500 million portfolio out of a bank or some other entity, a pension fund, that would make for a better deal if we had to buy at a high price.

Scarpa:  There’s been an increase of secondary buyers wanting to use leverage and a number of banks willing to lend, so that’s just added to the amount of capital in the market.

Leverage has made the larger end of the market, in particular, more competitive.  Large diversified portfolios, for example, are being aggressively pursued by buyers that have access to leverage and are willing to pay high prices.  Lenders, in turn, are anxious to lend against larger, more diversified portfolios.

Privcap: What debt levels are generally available for secondary deals?

Cassidy: The amount of advance against the dollar of portfolio value is anywhere from 20% to as high as 50%. The pre-bust period was also characterized by a group of active lenders who then promptly disappeared, with the exception of one or two, during the post-collapse period.

And so you’ve seen the full cycle there. The difference being that during the bust, those loans all basically became under-collateralized, and caused a lot of rippled distress within the secondaries universe broadly.

Privcap: Are some secondary buyers gaining an edge by offering to become a major LP in the next primary fund?

Cassidy: What I’ve seen more often than not is a secondary relationship transform into a primary relationship as opposed to going the other way. It gives you an incremental source of knowledge about GPs, and obviously you could conclude that they’re of a quality that could go in your primary blind-pool portfolio. On the GP side, there is always a preference for stickier money. And so to the extent that GPs are looking for primary capital, secondary players may or may not constitute that type of capital. That relationship dynamic has become much more sophisticated over the last four or five years.

Privcap: What types of sellers do you see emerging as important sources of deal flow in the secondaries market?

Scarpa: I think we’ll see increased activity by banks.  The ones that have not sold will need to comply with the Volcker Rule.  They’ve delayed and delayed but they are required to comply by July 2017.

We also continue to see pension plans, particularly in the US, that are actively culling their overly diversified portfolios. They’ve invested in too many managers and too many funds, and they’re using the secondary market as a portfolio management tool to rationalize their relationships. That’s not a trend that’s going to reverse itself. You’ve got very small teams managing these portfolios at these pension plans.

Cassidy: There are some very large plans that started with hundreds of names in their portfolio, and now they’re down to a little less than 100. And their goal is to get down to less than 50. So once they get to that steady state, they’re done. And I expect there to be some sort of bottom in the next couple of years.

Privcap: With so much competition and capital in the secondaries space, how are buyers distinguishing themselves from other potential buyers?

Scarpa: There continues to be inefficiency in the secondary market that can be exploited.  With the increased capital in the secondaries market, however, it’s critically important for a secondary buyer to have a competitive advantage in the marketplace, to have longstanding relationships with general partners, to have an information edge and unique insight into these portfolios and to ultimately be able to identify relative value across portfolios.  For secondary buyers that don’t have a distinct competitive advantage and have instead relied solely on large discounts to generate returns, they will struggle to be successful.

Cassidy: On the plus side, if you’re talking about taking down multi-billion dollar portfolio, there are not many firms that can do that. On the other hand, that’s not the typical deal.